Credit Suisse's $84.56 million leveraged notes linked to S&P 500 fit bulls' buoyant outlook

By Emma Trincal

New York, Jan. 30 - Several large leveraged notes offerings priced last week, leading some sources to question either the timing or the use of structured notes for those trades as the upside was attractive but the downside protection lacking.

The largest and most noticeable deal was Credit Suisse AG, Nassau Branch's $84.56 million of 0% Accelerated Return Notes due March 28, 2014 linked to the S&P 500 index, according to data compiled by Prospect News.

The payout at maturity was par plus 300% of any index gain, capped at 11.52%. Investors were exposed to any losses, according to a 424B2 filing with the Securities and Exchange Commission.

Complacency

"I do see demand for these non-buffered leveraged notes because there are advisers and investors out there who are getting more aggressive," said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

"We prefer leverage with buffers, even if the buffer is small. As a matter of fact, the two leveraged deals we bought last month had buffers.

"We're hired for the protection of the assets. We have limited control over these products. ... It's not like you can get in and out of the trade. So we like to do a little bit of damage control in the event of a downturn," he said.

Pool said that whenever the market rises, as it has since the beginning of the year, investors feel more confident about taking risks.

"The rally is making investors more comfortable," he said.

But investors might be getting too comfortable, and complacency often has a cost, he warned.

"Investors have pretty short-term memories. They like what they're seeing in the new market highs and they tend to be optimistic," he said as a reason for investors to bid on leveraged products with no barriers or buffers against downside risk.

"We tend to be a little more cautious. People should be buying at the lows, not at the highs," he said.

Philip Davis, hedge fund manager at Capital Ideas, said that options may offer better alternatives in terms of risk versus reward. Commenting on the Credit Suisse deal, he said that, "This is my issue: the S&P drops 10%, you lose 10%. For me, from the perspective of a stock option trader, there are better ways to do that trade or at least to get yourself some cushion against some of the losses."

He looked at the options expiring at the same time as the notes in March 2014. He picked the SPDR S&P 500 exchange-traded fund, listed on the NYSE Arca under "SPY," which sells at one-tenth of the S&P 500 index price.

"This note is not bad looking at what's out there. I would say it's not so easy to replicate it with an option. It's tricky," he said.

Building protection

However, Davis suggested two option trades, which in his view may offer more appeal from a risk versus return standpoint.

The first one was a put sale.

"I could sell the SPY March 2014 150 at-the-money put for $12," he said.

With this trade, the investor is obligated to buy the shares at the $150 strike if the ETF drops below that price. The strike is "at the money" because the index is currently trading at this level, he explained.

"I'm getting $12 up front, so my real entry point is $138."

Each option contract commands 100 shares of the underlying asset. In his example, the investor gets paid $1,200 to make the commitment of buying the shares at the net cost of $13,800.

"That's an 8.7% return," he said comparing the amount of premium received with the net cost of purchasing the shares if the option were exercised.

"I make 8.7% as long as the S&P 500 is flat or higher than its current price.

"The advantage is that I don't have to pay anything unless it's below.

"Other advantage: this 8.77% return is the equivalent of a buffer. It gives me the downside protection that I don't have with the structured product. So I don't have the 11.5% return, I only have 8.7%. But I have the downside protection. To me, it's a better risk/reward," he said.

Bull call spread

Davis proposed a second example with a so-called bull call spread on the SPDR S&P 500 ETF.

In this option strategy, the investor sells and buys two calls at different strikes. The short call is higher than the long call. By selling the call, the investor reduces the cost of buying the call. However, by the same token, the profit is limited to the higher strike.

"This one may offer a better way to beat the 11.5% return," he said.

"I could sell the March 2014 150 call for $8.66 and buy the March 2014 135 call for $18.66. This $15 spread costs me $10."

The investor would make money if the SPY rose above the long call strike of $135. But the price should also close above the other strike of $150 in order for the put sale not to be exercised, he explained.

The net cost of the trade is the difference between the premium received from the put sale and the cost of buying the call, which in this example would be $10, he explained.

The $15 spread represents the potential gain on the trade, he added.

"I can make $15 as long as the shares finish above the 150 strike. That's my spread. I put in $10 on this trade. If I make $15 out of $10, that's a 50% return. You're creating tremendous leverage with a 50% gain," he said.

The leverage enabled investors to reduce their overall exposure and limit the risk.

"You just have to put in the money that you need," he said.

"Say you have $3,000 and you only want to invest 30% of that. You put down $1,000. If you get a 50% return on that $1,000, it's the equivalent of making 16.5% on your capital. That one lets you beat the return of the notes.

"You also get more protection. Say the S&P 500 is down 30%. Losing 30% on $1,000, which is just a third of your money, is exactly the same as losing 10% of your $3,000. You're limiting your total loss. You're not trapped in it like with the structured product. It's flexible. It allows you to get out."

The notes (Cusip: 22539T845) carried a 2% fee.

The deal priced on Jan. 24. Bank of America Merrill Lynch was the underwriter.

Bank of America Corp. issued two other big capped, non-buffered leveraged notes with a 300% upside participation: one was a $66 million issue of two-year notes linked to the S&P 500 with an 18.08% cap. The other was a 14-month product referencing the Russell 2000 index. The cap was 15.66%.

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